Public debt and financial crises: connections and attempted solutions

Abstract

This paper traces the actions that have been taken to address the numerous waves of crises that have repeatedly hit the financial system since 2007, from the perspective both of public debt managers and financial regulatory authorities.

In particular, in the first part emphasis is placed on the need for DMOs to adapt promptly methods and strategies of issuing government bonds, combining flexibility, transparency and consistency in their market approach, at the same caring the smooth functioning of secondary markets.

Thus, it is illustrated the remedies adopted to deal with the many phases of crisis, of varying nature, that have succeeded one another since the emergence of the subprime bubble. Such solutions had to be implemented in a very harsh environment, especially during the sovereign debt crisis in Europe, when the uncertain process of addressing problems by the EU institutions induced further deterioration to market sentiment. The new approach adopted by the ECB since the second half of 2012 favoured a gradual normalisation of market conditions, even if new difficulties emerged in a context of rapid structural changes. But the outbreak of the pandemic and the recent geopolitical tensions have continued to produce challenges to debt managers, forced to increase the volume of bond issuance and ensuring a smooth refinancing process. Therefore, it is important for DMOs to maintain a long-term perspective that can reassure market participants, while the risk potential inherent in a high level of debt must never be neglected.

The second part introduces the fact that the European regulatory framework post-2008 was shaped by the need to break the "doom loop" between sovereign debt and banking instability. This vicious circle highlighted deep weaknesses in Eurozone governance, where the freeze in cross-border capital flows often led banks to hold excessive amounts of domestic public debt, amplifying mutual vulnerabilities.

To address these challenges, the Banking Union was launched in 2012, based on three pillars: the Single Supervisory Mechanism (SSM), the Single Resolution Mechanism (SRM), and a Single Deposit Guarantee Scheme (SDG). While the first two have harmonized supervision and crisis management, the third remains incomplete due to the persistent link between public funding and national banking systems.

Basel reforms further strengthened the system by introducing stricter capital and liquidity requirements (prudential buffers) to increase loss-absorbing capacity. Simultaneously, the latest regulatory efforts (such as CMDI and the SRB) aim to move beyond the "too big to fail" logic, reducing the burden on taxpayers through long-term debt instruments that can be written down or converted during a resolution.

In the context of "permacrisis," a sovereign’s stability remains inseparable from its banking health: strong banks ensure effective monetary policy transmission and financing for the real economy, while sound fiscal policies protect bank assets. The final challenge remains the implementation of a common safety net (EDIS) to fully complete the European financial architecture.